Friday, April 25, 2014

Overruling long-standing precedent, the California Supreme Court recently held that parol evidence may be admissible to show that a written contract was fraudulently procured. In so ruling, the Court overturned the so-called Pendergrass rule, partly because Pendergrass contradicted a California statute expressly allowing evidence to establish fraud and the resulting invalidity of a written agreement.

Plaintiffs borrowers ("Borrowers") fell behind on mortgage payments to defendant lender ("Lender"). Lender and Borrowers later entered into a loan restructuring agreement according to which Lender would take no enforcement action for three months as long as Borrowers kept up with the new payment plan. According to the contract, Borrowers pledged additional collateral consisting of eight parcels of land. In executing the new loan agreement, Borrowers initialed the pages containing the legal descriptions of the parcels and signed the agreement without first reading the contract.

Borrowers failed to make the required payments under the loan restructuring agreement, and Lender commenced a foreclosure action against them. Borrowers eventually repaid the loan,and the foreclosure proceedings were accordingly dismissed.

Nevertheless, Borrowers filed a lawsuit asserting causes of action for contract rescission and reformation of the loan restructuring agreement, seeking damages for fraud and negligent misrepresentation. Borrowers' complaint alleged that Lender had verbally promised that the loan would be extended for two years in exchange for additional collateral consisting of only two pieces of real estate rather than the eight parcels indicated in the written agreement.

Lender moved for summary judgment, arguing that Borrowers could not prove their claims because the parol evidence ruled barred evidence of any representations contradicting the written agreement. In response, Borrowers asserted that Lender's supposed misrepresentations were admissible under the fraud exception to the parol evidence rule.

The Court of Appeal reversed, reasoning that Pendergrass applied only to cases of promissory fraud rather than instances of factual misrepresentations consisting of false statements about the contents of the agreement itself. Lender petitioned the California Supreme Court for review, which affirmed.

As you may recall, the codified parol evidence rule in California provides that "[t]erms set forth in a writing intended by the parties as a final expression of their agreement with respect to such terms as are included therein may not be contradicted by evidence of any prior agreement or of a contemporaneous oral agreement" and, further, that "[w]here the validity of the agreement is the fact in dispute, this section does not exclude evidence relevant to that issue." Cal. Code Civ. Proc. § 1856, subdivisions (a), (f). See also Cal. Code Civ. Proc. § 1625 ("[t]he execution of a contract in writing, whether the law requires it to be written or not, supersedes all the negotiations or stipulations concerning its matter which preceded or accompanied the execution of the instrument.").

In addition, California law expressly allows for the admission of evidence to establish fraud in the procurement of a written contract. See Cal. Civ. Civ. Proc. § 1856, subdiv. (g).

In reviewing the history and purpose of the parol evidence rule, the California Supreme Court noted that Section 1856 broadly permits evidence relevant to the validity of an agreement itself, rather than the terms of the written contract, and, further, that Section 1856 specifically allows evidence of fraud in challenging the enforceability of a written agreement. The Court also opined that Pendergrass was inconsistent with the principle, incorporated in numerous Restatements and espoused by a majority of other jurisdictions, that evidence of fraud is not affected by the parol evidence rule.

Pointing out, among other things, that the Pendergrass limitation on evidence of fraud is in this Court's view bad public policy, as it may actually further fraudulent practices by turning the parol evidence rule into a means to protect such conduct, the Court stressed that the 1977 proposed modifications to the statutory formulation of the parol evidence rule completely omitted references to Pendergrass and its non-statutory limitation on the fraud exception. The Court observed that, significantly, those modifications made no substantive changes to the statutory language allowing evidence that goes to the validity of an agreement, particularly evidence of fraud. See Coast Bank v. Holmes, 19 Cal. App.3d, 581, 591 (1971).

The Court further noted that the Pendergrass restriction on the fraud exception was not only inconsistent with the parol evidence statute, but also with California case law at the time and legal scholarship, as the opinion failed to take into consideration "the fundamental principle that fraud undermines the essential validity of the parties' agreement. When fraud is proven, it cannot be maintained that the parties freely entered into an agreement reflecting a meeting of the minds."

Noting that "[t]he distinction between promises deemed consistent with the writing and those considered inconsistent has been described as 'tenuous,'" and stressing that Section 1856 represents what this Court saw asbetter public policy, the Court overruled Pendergrass and its progeny, and further pointed out that Borrowers would still have to show justifiable reliance on Lender's misrepresentations in order to prove promissory fraud in their case.

Accordingly, the Court affirmed the judgment of the Court of Appeal, but on different grounds.

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